Modern Phillips Curve

12 Key excerpts on "Modern Phillips Curve"

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  Asymmetry and Aggregation in the EU

  • D. Mayes, Matti Virén(Authors)
  • 2011(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  77 4 The Phillips Curve The Phillips curve provides the key link between the real economy and inflation and lies at the heart of our analysis. Although there are various asymmetries involved in the relationship the most obvious facet is that the relationship is referred to as a curve. Although in many models it is estimated as a linear relationship in part because of the difficulties that Phillips himself encountered in the original estimation (Phillips, 1958). Indeed it is only partly an accident of history, with the collapse of the long-run regularity and its replacement with a short-run expectations augmented curve (Phelps, 1967), that it has frequently been estimated as a straight line. 1 In Phillips’ original specification, the rate of change of money wages is related to the rate of unemployment and described as a regularity without any formal attempt at a firm theoretical basis. Since then, in addition to including price expectations following Phelps (1967) and Friedman (1968) and later rational expectations (Lucas, 1976), the ten- dency has been to replace wage inflation with price inflation and fre- quently to use the output gap instead of unemployment as a measure of the pressure in the economy. We deliberately do not take a stand on what is the most appropriate specification. In Paloviita and Mayes (2006), we have examined a number of common versions of the models including expectations from the ‘new classical’ model using last period’s expectations to the ‘pure’ New 1 The discussion of the Phillips curve remains contentious. Gordon (1997) main- tains that it is ‘resolutely linear’ in the US while Stiglitz (1984) suggests that it could have the opposite curvature with firms being more reluctant to raise rather than lower prices. Yates (1998) offers a helpful classification of the main different factors that could lead to nonlinearity. Keynesian model, which uses this period’s expectation of future inflation.

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  An Introduction to Economic Dynamics

  • Ronald Shone(Author)
  • 2001(Publication Date)
  • Cambridge University Press

    (Publisher)

  6.1 The Phillips curve Most discussions of inflation begin with the Phillips curve, and we shall be no exception. We shall, however, concentrate on those aspects that are important for the dynamics of inflation and unemployment. There are basically two spec-ifications for the Phillips curve: the basic one relating inflation to unemploy-ment, and the expectations-augmented Phillips curve, which relates inflation to unemployment and expected inflation. In general terms these are f ( u ) f ( u ) e where inflation, e expected inflation and u unemployment. For the moment, we shall assume a simple inverse relationship between inflation and unemployment, i.e. we assume a 0 a 1 u a 0 , a 1 0 It is not our intention here to present a full discussion of the Phillips curve, and we simply state that the natural level of unemployment, u n , is the value of unemployment which satisfies the condition f ( u n ) 0 and e . Given our linear Phillips curve, then u n satisfies the condition u n The situation is illustrated in figure 6.1, where we have drawn an expectations-augmented Phillips curve. Of course, to draw such a Phillips curve we must assume that expected inflation is given, which we shall do for the moment. In more recent treatments of the Phillips curve it has been convenient to specify the relationship between inflation and the level of real income. This is because we need to include the Phillips curve into a broader model of the macroeconomy. This takes the form ( y y n ) e 0 where y is real income and y n is the natural level of income associated with u n . But underlying this relationship are two reaction functions, which are worth spelling out. The first is a slightly reformulated Phillips curve that relates infla-tion to the unemployment gap, i.e. 1 ( u u n ) e 1 0 a 0 a 1 (6.1) (6.2) (6.3) (6.4) 110 Chapter 6 Inflation–unemployment dynamics The second is Okun’s law, which relates the unemployment gap to the income gap, i.e.

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  The Economics Companion

  • Graham Mallard(Author)
  • 2017(Publication Date)
  • Red Globe Press

    (Publisher)

  In the 1960s Robert Solow and Paul Samuelson showed the relationship to hold more generally between the rates of inflation and unemployment, which led to the conventional Phillips curve displayed in Figure 11.7b. Key term: the Phillips curve The Phillips curve shows a negative association between the rates of inflation and unemployment of an economy. The implication of the Phillips curve is that the government can choose which combination of inflation and unemployment prevails in the economy. If 223 unemployment, money and inflation 3 3 it thinks the inflation rate is too high it can reduce it, but at the cost of greater unemployment. Likewise, if it thinks unemployment is too severe it can reduce it, but at the cost of greater inflation. By integrating the Phillips curve relationship into our analysis of the previous section, we can enrich our conclusions. To do so, though, we need to transform the conventional Phillips curve. Instead of measuring the unem-ployment rate on the horizontal axis we need to plot the relationship in terms of the economy’s output level, which creates the mirror image of the curve in Figure 11.7b. The combined model is displayed in Figure 11.8. The upper panel shows both a recessionary and inflationary gap, caused by the aggregate demand curve shifting to AD 1 and AD 2 respectively. The lower panel displays the horizontally inverted Phillips curve, which shows the change in the price level caused by a recessionary gap is less than that caused by an inflationary gap of equal size. The inflation caused by the inflationary gap, denoted by ˙ P 2 , is larger in absolute terms than the deflation caused by the recessionary gap, denoted by ˙ P 1 . This is one reason why economists tend to focus on inflation: it can become a serious problem quickly. We can now include the role of inflationary expectations into the analysis: the level of inflation that actors within the economy expect to prevail.

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  Applied Intermediate Macroeconomics

  • Kevin D. Hoover(Author)
  • 2011(Publication Date)
  • Cambridge University Press

    (Publisher)

  614 The Dynamics of Output, Unemployment, and Inflation 6. Price-setting firms choose optimal prices relative to the general price level. In order to achieve the desired relative price, they must set prices in antici-pation of future inflation. The relative prices of the goods they produce are likely to be modified to take account of cost pressures (supply) or demand pressures. 7. The (expectations-augmented) Phillips curve aggregates the price-setting behavior of firms to find a relationship between inflation, relative to expected inflation, and a measure of aggregate demand (aggregate-supply factors may also be considered). Aggregate demand (relative to aggregate supply) is often measured by the unemployment rate. The Phillips curve may be written as: ˆ p t − t − 1 ˆ p e t = − β ( U t − U ∗ ) + g ( aggregate-supply factors t ), where U ∗ is the natural rate of unemployment , defined as the rate that keeps actual and expected inflation in agreement. 8. Expectations are frequently measured on the assumption that this period’s infla-tion rate will be the same as last period’s. Then the Phillips curve may be written as: ˆ p t = − β ( U t − U ∗ ) + g ( aggregate supply t ). In this version, U ∗ is frequently referred to as NAIRU , the non-accelerating inflation rate of unemployment. 9. Other measures of aggregate demand relative to supply can be used in the Phillips curve, such as scaled output. Then NAIRU would be interpreted to mean non-accelerating inflation rate of resource utilization. 10. NAIRU (or the natural rate of unemployment) is not constant over time, but may vary with changes in real factors, such as demographics or the organization of labor markets. 11. The role of expectations in the Phillips curve highlights the importance of cred-ibility in demand-management policy: reducing inflation is less costly in terms of unemployment or other unused resources if the public believes that policy-makers will actually be successful in reducing it.

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  Brookings Papers on Economic Activity: Spring 2019

  • Janice Eberly, James H. Stock, Janice Eberly, James H. Stock(Authors)
  • 2019(Publication Date)
  • Brookings Institution Press

    (Publisher)

  Trying to fit the same model to these two distinct periods invites policy mistakes. For example, current monetary policy—namely, inflation targeting—assumes that some modest amount of inflation can maximize employment regardless of the institutional setup of wage and price setting. Stefano Eusepi thanked the discussants for their observations, promis-ing to incorporate them into the paper. First, he addressed critiques of the Phillips curve by making a distinction about how exactly it has flattened in recent years. Namely, in their model, with the same size of the output gap, they can explain both the low inflation since 2008 and the high inflation of the 1970s. The reason for this is that the Phillips curve has only flattened in one dimension: its relationship with the current unemployment gap. It has not flattened in relation to the present discounted value of future unemployment gaps. This creates a situation where even if the unemploy-ment gap is large, but it is expected to revert back to zero, then the Phillips curve is quite flat and inflation does not react. However, if the gap is expected to be permanent, then the slope of the Phillips curve can be quite large and inflation does materialize. In this way, the Phillips curve is not actually flat. Eusepi also commented on the formation of inflation expectations. Although their current paper does not model inflation expectations, he noted other papers the authors had written on the behavior of long-term inflation expectations that vary endogenously with monetary policy. 9 These models can explain inflation expectations based on survey data, both in the 1970s and today. James Stock referenced comments from Frederic Mishkin and Laurence Meyer on the flat Phillips curve. He asked about how inflation expectations are developed and their relationship with monetary policy. In this context, if the unemployment rate were expected to increase by a large amount, then monetary policy should respond by a large amount.

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  Macroeconomic Theory: A Short Course

  A Short Course

  • Thomas R. Michl(Author)
  • 2015(Publication Date)
  • Routledge

    (Publisher)

  10.5: Starting from a long-run equilibrium (A), an increase in the rate of growth of the money supply from 5 per cent per year to 6 per cent per year causes the system to move along its Phillips curve in the short run (B). Because inflation expectations chase after actual inflation, next year’s equilibrium lies on the new Phillips curve (C). Ultimately, the system will achieve the new long-run equilibrium (D). The arrow shows the path taken when the model has a stable focus, which involves overshooting the equilibrium.

  In its first period, the policy moves the economy along its existing Phillips curve. Since workers follow adaptive expectations, they believe that the inflation rate will remain at its original level (the old long-run equilibrium inflation rate).

  In its second period, the policy works through both dynamic processes we described above. The Phillips curve shifts upward because the expected rate of inflation, which positions the Phillips curve, chases after the actual rate of inflation, which rose in the first year. The unemployment rate in Figure 10.5 has continued to decline, because the inflation rate is still below the new growth rate of the money supply set by the central bank.

  At some point in time, the economy will reach a turning point where the unemployment rate will cease dropping and begin to rise. This will occur when the inflation rate rises above the growth rate of the money supply. The Phillips curve will then be shifting upward and the unemployment rate will be rising, so that inflation and unemployment increase simultaneously, a phenomenon known as stagflation. The ability of the expectations-augmented Phillips curve to explain the stagflation of the 1970s played a major role in its acceptance by the economics profession.

  Another turning point is reached when the unemployment rate rises above the natural rate of unemployment. As we have seen, in this configuration the Phillips curve shifts downward over time because inflation expectations overestimate inflation, and are being revised downward. The economy experiences falling inflation and rising unemployment until the next turning point is reached.

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  Macroeconomic Policy Since the Financial Crisis

  • Matteo Iannizzotto(Author)
  • 2023(Publication Date)
  • Agenda Publishing

    (Publisher)

  3 Behind the three equations II: inflation and the Phillips curve

  3.1 Inflation and the Phillips curve

  It must be remembered that the Phillips curve is first and foremost an empirical relationship that was originally meant to relate wage inflation and unemployment (Phillips 1958 ). Ever since it has been in search of a theoretical justification that has come in different guises and sometimes these have also been radically different. In the context of the three-equations model (or the DSGE) it is meant to represent the behaviour of inflation relative to some measure of the output gap. Stripped of all deeper theoretical foundations, that is its bare purpose. Inevitably, when one examines what lies behind it, one is forced to examine inflation per se. It is in the treatment of this crucial economic variable and the Phillips curve that purports to represent it, that the greatest and deepest discrepancies will be found between the three-equations model and the DSGE. But in order to see this in greater detail, some general questions about inflation will have to be addressed.

  In its barest form, inflation just means a positive rate of growth in prices. How it comes about and what justifies it can be done in different ways. In particular a general distinction can be made between demand-pull and cost-push inflation. The first case, in intuitive terms is when demand outstrips supply and prices have to rise. Another way of looking at it is to say that it is a case of excess demand. These instances have already been represented in the diagrams of the first chapter in all the cases where the first shock was one on the IS curve (permanent or temporary) making it true that current output would exceed equilibrium (or otherwise put, the output gap is positive). Consistently with the specification of the Phillips curve, the positive output gap on the right-hand side causes inflation to rise on the left-hand side.1

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  Multimod Mark III : The Core Dynamic and Steady State Model

  • Hamid Faruqee, Douglas Laxton, Bart Turtelboom, Peter Isard, and Eswar Prasad(Authors)
  • 1998(Publication Date)
  • INTERNATIONAL MONETARY FUND

    (Publisher)

  If monetary policy becomes highly inflationary, for example, the proportion of myopic agents would decline, the speed of learning would increase, and the prevalence and average duration of multiperiod nominal contracts would decline. In practice, however, almost all macro models describe the supply side of the economy with a Phillips curve, given the strength of the empirical correlations in historical data and the lack of more attractive alternatives. This is also the case in MULTIMOD, which treats the Phillips curve as a structural relationship. That being said, we regard it as incumbent on model users to avoid subjecting their models to policy experiments for which the underlying assumptions about inflation expectations would break down. When specifying a Phillips curve relationship in the form of equations (6) and (7), it is important to place a positive weight on the model-consistent expectation (that is, Φ > 0). Otherwise, the model is inconsistent with the LR-NRH, since with Φ = 0 it would always be possible for the monetary authorities to fool people systematically and raise the level of output in the long run by continuously increasing the rate of growth of the money supply. 45 The condition that Φ > 0 implies that the long-run Phillips curve is vertical and that real variables, such as the unemployment rate, are tied down by real factors, such as tastes and technology, and are to a first approximation independent of both the level of the money supply (the condition of monetary neutrality) and the rate of growth of the money supply (monetary superneutrality)

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  Monetary Economics

  Policy and its Theoretical Basis

  • Keith Bain, Peter Howells(Authors)
  • 2017(Publication Date)
  • Red Globe Press

    (Publisher)

  Expected inflation no longer depends on past infla-tion but on expected monetary policy. The assumption of continuous market clearing implies that prices are free to adjust instantaneously to clear markets. It follows that anyone wishing to work can find employment at the market-clearing equilibrium wage and thus that all unemployment is voluntary. The combination of the rational expectations hypothesis and the assumption of continuous market clearing implies that output and employment fluctuate randomly around their natural levels. Thus, unem-ployment fluctuates randomly around the NAIRU. All we are left with of the Phillips curve is the vertical line at the NAIRU. Increases in aggregate demand do not produce systematic reductions in unemployment, even in the short-run. All they do is increase inflation. Acceptance of the New Classical model denies that there is any advantage to be had from demand management even in the short-run. Money is neutral in both the short- and the long-run. Another way of making the same point is to say that rational market agents fully anticipate the actions of the authorities and incorporate this information in their expectations of the rate of inflation. That is, if the monetary authorities seek to increase the rate of growth of the money supply (or, more realistically, seek to cause short-term interest rates to fall) in the hope of reducing unemployment, market agents realize this and correctly forecast that the rate of inflation will rise. Workers then push wages up in line with the correctly forecast inflation and real Aggregate demand, output and prices 164 Pause for thought 6.4 Compare the nature and formulation of the original Phillips curve with the PC curve in the IS/PC/MR model. * 1 1 2 . .( ) t t t M Y π α π α − = + − (6.6) M Y wages, employment and output all remain unchanged. The level of unemploy-ment does not fall.

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  Monetary Economics

  Theories, Evidence and Policy

  • David G. Pierce, Peter J. Tysome(Authors)
  • 2014(Publication Date)
  • Butterworth-Heinemann

    (Publisher)

  We assume that initially the economy is in long-run equilibrium with output and employment at their natural levels. The expected rate of inflation is equal to the actual rate of inflation, which for simplicity's sake we will assume is zero. In Figure 9.8 the economy is at point ί /η· The emergence of the excess demand will result in a north westerly movement along the short-run Phillips curve labelled PC{P^ = 0). Let us assume that the excess demand is sufficient to move the economy to point A where unemployment has fall to i /i, but the rate of inflation has risen to 3 % . With adaptive expectations the divergence between actual and anticipated inflation rates will disappear and there will then be a movement back to the natural rates of unemployment and output, i.e. a movement to point B. At this point inflation is proceeding at a steady 3 % . In the absence of any expansion of the nominal money supply the inflation will depress the real value of the money balances held by economic agents below their desired levels, given the pattern of relative real yields. Interest rates will rise and via a process of portfolio adjustment expenditure will fall. The fall in expenditure will lower output and employment below their natural levels and reduce the rate of inflation. In Figure 9.8 there will be a movement in a Market theories of inflation 209 3% Long-run Phillips curve ik:^ ^.^^.^^ Β X υ ^PC (P'=3%) ^ PC (P'= 0%) Figure 9.8 A falling rate of inflation due to a fixed money supply In the foregoing illustration we assumed that inflation did not start to reduce aggregate demand until the long-run equilibrium rate of inflation had been reached. It is of course probable that this effect on expenditure will happen much sooner, in which case the adjustment path is rather different to that shown in Figure 9.8. The illustration also ignored any effect inflation expectations may have on the demand for real money balances.

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  Macroeconomic Theory and Macroeconomic Pedagogy

  • G. Fontana, M. Setterfield, G. Fontana, M. Setterfield(Authors)
  • 2016(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  If, in addition, the response of inflation to output is lagged, the central bank will have to forecast the Phillips curve a further period ahead and the Taylor Rule will take its familiar form to include contemporaneous inflation and output shocks. The 3-equation (C–S) model provides access to contemporary debates in the more specialized monetary macroeconomics literature. As shown in Carlin and Soskice (2005), it is straightforward to demonstrate the origin of the time-inconsistency problem using the graphical approach. All modelling in economics needs to be taken with a pinch of salt. Our purpose is to provide a simple tool-kit for analysing most common situa- tions. Three concluding remarks are important: (1) In this chapter, we do not discuss in any detail how y e is derived: the example shown in Figure 1.5 indicates how changes in the real cost of raw materials, including food and energy, are reflected in the interaction of price-setting and wage-setting real wage curves. The structural effects of tax changes can be shown in a similar way, as can shifts in productivity and institutional and policy characteristics of the labour and product markets. (2) Autonomous demand A is proba- bly the most difficult component to forecast particularly when household and business expectations are changing. And the ability of the CB to ‘pick’ future output by current changes in r is most suspect under such volatile conditions. Finally (3) the chapter focuses on the closed economy. Although we have introduced the analysis of an oil price shock, we have not pre- sented a full model of the open economy to include the role of exchange rate determination. As we show in our textbook (2006), the role of the real exchange rate in the open economy leads to some important changes in analysis. Appendix 1.1 The central bank’s loss function: graphical representation The geometry of the central bank’s loss function can be shown in the Phillips curve diagram.

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  Economics of Transition

  A New Methodology for Transforming a Socialist Economy to a Market-led Economy

  • Hüsnü Kizilylli(Author)
  • 2019(Publication Date)
  • Routledge

    (Publisher)

  Following empirical findings and observations, are crucial in winding up this issue: Large movements in output occur with small movements in real wages over business cycles; during booms employment is high and conversely in recessions. Moreover the empirical evidence does not support the view that the intertemporal substitution of leisure explains the fact that small changes in wages can cause large output effects in the cycle. Workers do not work more in booms because of higher wages, since “constancy of the real wage is a reasonable approximation to actual wage behavior” and under the markup pricing rule the real wage becomes constant and employment changes with aggregate demand (Dornbusch and Fischer, 1990, pp. 691-92). Hence, the explanation for workers’ and firms’ behaviors in response to price and wage inflation supporting the Phillips trade-off is not valid. Labor supply responds to nominal wage increase not because workers are ignorant of the real wage level and firms do not increase output and employment because of the wrongly assumed increase in their expected, profitability through lag in wage adjustments, since real wages are constant anyway in a business cycle and the assumed cost advantage and profitability increase, if any, is of minor significance; one concludes that labor supply increases if labor demand rises and output/employment increases only in response to the aggregate demand increase. Particularly, in inflationary conditions, changes in prices and availability of critical inputs, imported materials and spare parts, high interest cost, expected change in the exchange rate, credit squeeze, possible labor strife, degree of capacity utilization and increasing uncertainty in general, might outweigh any cost advantage arising from lagged adjustment of wages and even expanding sales prospects.

  Some regression equations are estimated for the US, Korea and Japan, to find out whether annual changes in real GDP have responded positively or negatively, if at all, to annual price (hence wage) inflation and fiscal expansion (government budgetary deficit). Data used are appended to Chapter 22 . This is a direct test of both the short-term Phillips curve trade-off (short-term, since no lagged effect is assumed in the specifications)(3 ) and crowding-out effects of budgetary deficits.

  This simple analysis does not prove any theory, but disproves the generally acknowledged beneficial effects on growth of budgetary deficits (or tax cuts for the US) and existence of any Phillips trade-off. Negative coefficients obtained for price inflation and government budgetary deficit indicate that these two factors rather reduce the growth rate of economic output. F-tests show that estimated regression coefficients are different from zero at 5%

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